Monthly Archives: July 2008

For years, Monetary Theory and the Trade Cycle and Prices and Production have been scarcely available and consequently at a steep cost. However, the Mises Institute has released a hardback volume that includes both texts as well as several essays by Hayek at a very reasonable price.

The U.S. Treasury and Federal Reserve, capping a weekend of high-stakes maneuvering, attempted to shore up confidence in Fannie Mae and Freddie Mac by announcing a plan that placed the federal government firmly behind the battered mortgage giants.

In a statement timed to precede the opening of Asian markets Monday, as well as a closely watched auction of debt by Freddie, the Treasury said it plans to seek approval from Congress for a temporary increase in a longstanding Treasury line of credit for the two companies.

The Treasury also said it would seek temporary authority so that it could buy equity in either company “if needed” to ensure they have “sufficient capital to continue to serve their mission” of providing a steady flow of money into home mortgages. The plan, which requires congressional approval, also calls for a provision to give the Federal Reserve a “consultative role” in the process of setting capital requirements and other “prudential standards” for Fannie and Freddie.

The Fed’s Board of Governors met Sunday in Washington and voted to grant the New York Fed authority to lend to Fannie Mae and Freddie Mac “should such lending prove necessary,” the central bank said in a statement. The move would effectively give the two companies access to the Fed’s discount window if necessary, providing a backstop in case the firms were to face a short-term funding crisis down the road.

Officials are hoping that, by promising bold action if needed, they can instill enough confidence in the battered companies that such intervention will ultimately prove unnecessary.

Meanwhile, James Hamilton has written an excellent post on how we got to this point.

The conventional wisdom is that inflation always hits the poor the hardest. Writing over at VoxEU, Christian Broda of the University of Chicago disagrees and suggests that the larger inflation burden falls on the richest households:

Inflation differentials between the rich and poor dramatically change our view of the evolution of inequality in America. Inflation of the richest 10 percent of American households has been 6 percentage points higher than that of the poorest 10 percent over the period 1994 – 2005. This means that real inequality in America, if you measure it correctly, has been roughly unchanged. And the reason is just as dramatic as the result. Why has inflation for the poor been lower than that for the rich? In large part it is because of China and Wal-Mart!

In Keynes’ General Theory, he explained that an equity market collapse could be blamed on either a weakening of confidence or of the state of credit — in modern parlance, these are referred to as “counter-party risk” and “liquidity risk” respectively. The importance of this observation, however, is given by Keynes subsequent assertion that “recovery requires the revival of both” (Keynes, 1936 [1973]: 158).

The point raised by Keynes is especially prescient given the current market turmoil. The realization that asset-backed securities were not worth what investors thought they were led to a collapse of both confidence and the state of credit. Financials were left wondering what the true size of their balance sheet was and therefore liquidity was in short supply, while simultaneously the increase in counter-party risk led these same institutions to be hesitant to lend. The result was a substantial increase in conventional measures of risk as reflected by the LIBOR-OIS spread and the TED spread as well as others. In an effort to ensure that both the collapse in confidence and of liquidity were reversed the Federal Reserve has taken drastic action. They have expanded the scope of the discount window through the Primary Dealer Credit Facility (PDCF) and have created the Term Auction Facility (TAF) to ensure that firms have the liquidity that they need. In addition, the federal funds rate was lowered precipitously to 2%. Thus, the major question is whether this has worked.

The conventional wisdom seems to be that the Federal Reserve has been moderately successful, but that they need to hold their course (i.e. not raise rates) to prevent a further exacerbation of the crisis. On the other hand, I have recently advocated a tightening of the federal funds rate in an attempt to stave off ever-growing inflationary pressures from a world awash in liquidity and therefore would like to submit the current data to closer analysis.

Currently the spread between the 3-month LIBOR (the London Interbank Offer Rate) and the Overnight Indexed Swap remains relatively high. Similarly, although the TED spread has gone down it remains elevated. In a recent paper by John Taylor and John Williams, they argue that these elevated risk spreads in the aftermath of the creation of the TAF suggests that it has not been successful. They may be correct, but I would like to float a different hypothesis. It is my view that the creation of the TAF and the subsequent creation of the PDCF have only satisfied one aspect of the recovery process, namely, an increase in liquidity. Whereas the programs increase the scope of the Federal Reserve’s role as lender of last resort thus ensuring that there is liquidity to be had, the programs have not succeeded in restoring confidence. In other words, the conventional measures of risk are reflecting counter-party risk, rather than liquidity risk. As the allusion to Keynes earlier highlights, it is not enough to start a recovery by merely providing liquidity; confidence must also be restored. Although the Fed had hoped that the creation of such programs would encourage firms to accept the same collateral, they have provided no such increase (or at least very little increase) in the state of confidence (as reflected in the still elevated conventional measures of risk).

If I am correct in my hypothesis, this would suggest that the rate cuts by the Federal Reserve have gone too far and have not contributed substantially to the increase in liquidity nor to the alleviation of the crisis. Under such circumstances, it would therefore prove prudent for the Federal Reserve to begin raising rates to stave off inflationary pressures rather than relying on others to do so. Unfortunately, my hypothesis also suggests that the crisis is here to stay for some time as the financials sort things out and until, ultimately, confidence is restored.

Unlike perishable agricultural products, oil can be stored in the ground. So when will an owner of oil reduce production or increase inventories instead of selling his oil and converting the proceeds into investible cash? A simplified answer is that he will keep the oil in the ground if its price is expected to rise faster than the interest rate that could be earned on the money obtained from selling the oil. The actual price of oil may rise faster or slower than is expected, but the decision to sell (or hold) the oil depends on the expected price rise.